China continues to slow, and the macro news will remain unflinchingly grim for several months. We are swamped by negative data points – manufacturing output, power generation growth and export orders are all down – but there is no reason to panic. The economy has entered what will be the worst part of the downturn, with GDP growth slowing to 8.5% in the fourth quarter, and then as low as 7% in the first three months of 2009. But by the second quarter of next year conditions will stabilize and then improve, putting full-year growth at 8%-plus.
There are many reasons why China won’t follow the US and Europe into an economic abyss.
Confidence. There has not been a loss of confidence in the Chinese financial system, and there is no risk of bank insolvency. All banks are backed by the Communist Party, which is stable, liquid and pragmatic. Most historical non-performing loans were removed from bank balance sheets, leaving them far stronger than during the Asian crisis. China also holds nearly US$2 trillion in foreign exchange reserves.
Liquidity. In China, there is only a credit crunch when the political leadership wants one. Chinese banks will lend when directed by the party, which appoints all senior bankers. Lending rose by 17.6% in September, up from 12% in January (on a quarter-on-quarter basis), and this will climb further following the central bank’s removal of lending quotas. Money supply growth indicates a high level of liquidity.
External debt. China’s external debt is relatively low. Along with a fairly closed capital account, this has helped insulate the country from much of the Western financial meltdown. China’s debt service ratio was just under 2% at the start of the year, the foreign debt ratio was under 30% and the ratio of short-term foreign debt to foreign exchange reserves was 14%.
Exports. China’s exports are holding up well, growing by 23.1% year-on-year in the third quarter, compared with 26.2% the same period last year. For the first nine months of this year, nominal export growth was 22.3%, down from 27.1% in the same period last year and 30.6% in 2006. The two largest export categories – machinery and electronics, which accounted for 58% of total exports last year – are slowing but remain very healthy. Most of the export growth slowdown has come from steel and garments. While falling demand in the US, Europe and Asia will knock more off of Chinese exports next year, overall growth should stay above 10% year-on-year. Net exports – the part of trade that contributes to GDP growth – have suffered more sharply: net export growth was 13% in the first nine months, compared with 51% for the same period last year. However, the overall impact of this is quite limited, as last year net exports accounted for only 16% of nominal GDP growth. When we worry about China’s overall economic growth, we should be worrying about domestic consumption and investment, not exports.
Consumption. Private consumption remains very strong. Retail sales rose 23.2% in September, just missing July’s 23.3%, which was the fastest pace in nine years. Consumer spending should slow in 2009, as real urban income growth has slowed this year, but private consumption should continue to be a strong driver of overall economic growth. (Remember that Chinese households have very high savings rates and almost no debt.) Real retail sales growth should not fall below 10% next year, from the current year-to-date pace of 14%.
Investment. Next year, fixed-asset investment (FAI) is likely to grow faster than the 25% year-on-year average of the past several years, which will compensate for some of the export slowdown. Investment growth in residential housing has dropped since June but overall new construction investment is on an upward trajectory. Land transfers are included in Chinese investment data so the increase in new construction includes the purchase and preparation of land, as well as actual construction activity. As such, an increase in construction investment in July would not necessarily translate into an increase in building rates until several months later. Meanwhile, central government spending on infrastructure was up 38% through August, compared with 16% last year – the largest fiscal stimulus program already under way, but one that has received little attention.
Producer prices and profits. Another reason to be optimistic about next year is that falling commodity and energy prices will result in rising industrial profits. Input price pressure continued to abate in September, as the purchasing price index (PPI) for industrial raw materials and fuel fell to 114 in September, down from the July peak of 115.4. Given the trends in global commodity prices, the PPI will continue to come down, which should lead to a gradual recovery in margins and profit growth in 2009. And while industrial profit growth has slowed from last year’s lofty heights, it hasn’t disappeared. Ex-energy sector industrial profits grew by 27.6% in the first eight months of this year, down from 38.4% through the first five months of the year, but not far off the full-year 2006 pace of 33.6%.
Real estate. Policy changes announced in October – a combination of lower interest rates, lower down-payments and lower transaction fees – represent a winding down of last year’s efforts to artificially depressing residential real estate sales in China. Having achieved its goal of cooling price growth, taking it from 25% year-on-year last fall to about zero today, the last thing Beijing wants to do now is crash the property market. With affordability good, household debt almost non-existent, and banks ready to lend (they are all controlled by the party), home buyers will respond by returning to the market. This will result in a significant pick-up in sales activity by mid-2009, which will in turn be followed by a rebound in prices across the country (except in Guangdong, which faces serious structural problems). A good time to look at residential developer stocks.
Potential to stimulate. Early last month, the government announced the first stage of a massive stimulus program designed to put a floor under the economy at 8% next year. Having run a budget surplus last year, as well as through the first eight months of this year, there is no doubt Beijing has the means to fund a stimulus for at least four quarters without worrying about a longer-term fiscal problem. China also needs a lot more infrastructure. The rail system is inadequate to move goods and people; many of the 600,000 villages lack a good road to the nearest market town; 300 million Chinese lack access to clean drinking water; and power generating capacity has risen rapidly without a commensurate investment in transmission and distribution capacity. A lot of infrastructure plans in the pipeline mean that spending can be accelerated at a rapid pace.
A long menu of administrative measures is also available to Beijing, including tax cuts, higher export rebates, interest rate cuts, as well as temporarily reduced enforcement of environmental and labor laws. None of these measures would promote healthy long-term growth, but they could be deployed on a temporary basis to prevent the economy from slowing below 8% next year.